China needs to address its currency before inflation takes root

10th December 2010

The news brought the usual round of hand-wringing from economists, central banks and governments around the world, who have been clear that China needs to do more to address its low currency and interest rates.

In this article, economists Lombard Street Research even talk of an ‘addiction to debt' in China. This sounds all too familiar and is discussed in detail by Nick Rice here.

In this Wall Street Journal article , Goldman Sachs economist Yu Song said: "Exceedingly strong exports growth amid an already overheated domestic economy is not good news, as it adds to the overheating pressures which will require the government to take even more stringent measures to bring down inflation."

The Chinese Government immediately announced limited monetary tightening , but for many people it is not quite the same as, say, an interest rate rise or an appreciation in the renminbi.

Although it demonstrates that Chinese policymakers are aware of the problem – the Chinese State Council formally changed its monetary policy from ‘moderately loose' to ‘prudent' last week – their measures are not sufficiently decisive for many. It can seem like the Chinese are complaining vociferously about the US's quantitative easing measures, while at the same time being unwilling to let the country's currency move to address the balance.

The question, however, is whether this matters for investors. Chinese companies still have strong balance sheets. The loan to deposit ratio for banks is among the lowest in the world. If anything, the Chinese market has significantly underperformed its peer group over the past three years.

Andrew Beal, manager of the Henderson TR Pacific investment trust, finds it hard to find real evidence of a bubble. He says: "Given its strong economy, the performance of the equity market has lagged. The question for next year may whether the stock markets can catch up with the economy."

He says that China unleashed all its policy tools in 2009 to ensure that the world didn't fall into a depression. It is now trying to normalise policy. He adds: "This pick-up in inflation is transitory. There has been a big policy switch to neutral and as it takes effect, people will become more relaxed."

However, Beal says that the remaining dilemma for policymakers across Asia is whether to allow their currencies to appreciate. This will become even more pressing if they raise interest rates. If the currencies do appreciate, Asia will regain control of its monetary policy.

Bubble or no bubble, China needs to address its currency before inflation takes root. Beal says that the jury is still out on whether that will be allowed to happen. Until it does, the bubble debate is unlikely to go away.